WEN CARDIAC ARREST

Takeaway:Looming risks facing the Wendy's system make the stock unattractive to us on the long side.

We’ve outlined our concerns about Wendy’s cash flow, given the years of intensive capex required to fix the system, since the analyst day back in January when the price tag of the turnaround ($3.7 billion) was brought to light.

Thoughts on the Quarter

We expect fixing the Wendy’s system to take another two years. Years of deferred capex has turned the company’s store base from an asset into a brand liability. It has taken CEO Emil Brolick the better part of a year to get the upgrade cycle going. As things stand, the vast majority of the initiative remains to be done. The company is working frantically to reimage stores in order to produce data and assure the investment and franchisee communities of the initiative’s viability.

The desire to demonstrate results is a positive but, on the other hand, it also implies an accelerating pace of spending and an increasing risk of earnings misses. Yesterday’s earnings announcement was mixed, at best, as operational metrics came in light besides same-restaurant sales. This company, by any conventional measure, is not producing free cash flow and likely will not for the next two years.

The comps during 3Q have vindicated management’s recent introduction of new menu items to increase consumer appeal. However, Brolick has emphasized the long-term importance of the asset base upgrade for gaining full credit from consumers for the upgraded menu. Where same-restaurant sales are in the fourth quarter is the key question for investors as the company laps the introduction of the Dave’s Hot ‘N’ Juicy Cheeseburger in October 2011. It is a strong possibility that comps are negative in 4Q with consensus expecting +1%.

Nothing Better To Do With Cash?

The biggest concern from the earnings release, for us, was the doubling of the dividend and a new $100 million share repurchase program. The board seems to be throwing money at the stock in order to support the share price which has been flat-lining for five years now. An owner of the stock yesterday was happy to learn that the dividend was going higher but the truth is that the company does – or should – have a better use for its cash.

Near-Term Uncertainty for Franchisees

Management announced a franchisee incentive program to get the larger, better-financed franchisees on board with the reimage program. As an observer, it’s difficult to know how the impact of these initiatives will play out over the near- and intermediate-term. As management has alluded to, the transformation of the Wendy’s brand will involve substantial turnover among the franchisee base. The journey from “mom and pop” franchisees to “mega” franchisees will, we believe, have a positive impact on the long-term health of the Wendy’s system. It is worth bearing in mind, however, that these transitions rarely occur without a hitch.

There are other factors, on the macro and micro level that are adding to franchisee blood pressure. On the macro side, Obamacare, commodity prices, and the fiscal cliff and its myriad possible consequences from a tax and economic perspective are weighing on the minds of operators. On the micro level, there has been some discontent among smaller franchisees at the level of investment required of them to partake in this (largely unproven) reimage initiative.

While we believe management can allay the micro-level concerns, the macro issues are unknown but could be especially meaningful for a company, like Wendy's, that is in transition. Our industry contacts continue to state that the implementation of Obamacare will be a negative for the restaurant industry. Franchisee communities which operate on thin margins, like Wendy’s, are particularly vulnerable.

The Latent Risks of the Franchised Business Model

In June, we held a conference call with John Hamburger of the Restaurant Finance Monitor and discussed the general perception of franchised companies as stable cash flow generators and the premium multiple that investors award the stock of such companies. Shares of BKW, DIN, DNKN, MCD, WEN, YUM & DPZ are some of the most richly valued in the restaurant space.

It makes intuitive sense to award a higher multiple to the shares of franchised companies but an important caveat is the prospective health of the constituent franchisees. Yesterday, Wendy’s stated that the impact of the healthcare overhaul will be “less than” (read: “around”) $25,000 per store. Assuming the company-franchise mix of ownership remains as it is, we calculate that Wendy’s could be facing a $0.10 hit to earnings per share. Given the company and franchisees’ need to reinvest in the business, it is important to look at the impact on franchisee cash flow. The impact of this new cost may amount to as much as 18-20% of store level cash flow for a ten-unit franchisee.

The looming impact of this, and other risks, is adding a real sense of urgency to the Wendy’s reimage initiative. For those taking a shorter-term view of the stock, accelerating spending during such an uncertain time implies a higher risk of earnings disappointments.

Howard Penney

Managing Director

Rory Green

Analyst

Share

Print

11/09/12 10:36 AM EST

Manheim Index Under Pressure?

The Manheim Index of Used Car Values rose in October by 1% on a month-over-month basis, an improvement but is still trending negative on a year-over-year basis. As of November 1, new vehicle inventory levels have been below 60 days (on a 12-month rolling basis) for the longest period ever. Low inventory in new auto sales means there’s a strong market there, putting pressure on used car sales.

Why do used car sales matter? Because the Manheim Index historically correlates closely to the S&P 500 and financials (XLF). Pressure on the used car market could be a harbinger for things to come in the broader market.

TUMI: How Low Can You Go?

Tumi Holdings (TUMI) looks weak right now and with the broader market selling off, it’s tempting to jump in and buy it. It’s important to note that TUMI just fell below its critical level of support at the TREND duration; we don’t see any support until the $17 level, so if you’re able to put temptation aside, you can likely snap up TUMI at a much lower price.

Risk Managed Long Term Investing for Pros

Buying On Red

Client Talking Points

Buy 'Em

The old adage of “buy on the low, sell on the high” still rings true these days. At Hedgeye, we’re buyers when the market is tanking and people are forced to sell. Basically, you’re in one of two camps: you’re either holding a lot of cash or you’ve got a buy list with names you’re ready to pick up on market weakness. We’re in the latter camp and today, we’ll be looking to pick up a few new names. We have a process and we stick to it. Right now, our signals are suggesting we buy stocks and sell bonds, so we’re going to go forward and do just that.

Think back to the 2000 bubble when it popped and everything went from triple digits to single digits in a matter of weeks (or delisted entirely). Those who took out their proverbial wallet and started buying on the low did what was right and generated a profit more than likely. It’s the same thing here, courtesy of post-election cynicism that has investors all riled up.

The Name's Bonds

Skyfall and 007 aside, the recent bullish bias in bonds has been quite obvious over the last several weeks with our Growth Slowing theme building day by day. With the 10-year Treasury only offering a yield of 1.61%, we think bonds are overbought here and the time is nearing to sell ‘em like you mean it.

Asset Allocation

CASH

55%

US EQUITIES

6%

INTL EQUITIES

0%

COMMODITIES

0%

FIXED INCOME

24%

INTL CURRENCIES

15%

Top Long Ideas

Company

Ticker

Sector

Duration

TCB

After a long downward slide, TCB has finally turned the corner. The margin has stabilized after the balance sheet restructuring. Loans are growing thanks to the equipment finance business. Non-interest income is more likely to go up than down going forward, a reversal from the past 18 months. Credit quality has a tailwind from a distressed housing recovery in TCB’s core markets: Minneapolis, Detroit and Chicago. On top of this, the CEO, Bill Cooper, is one of the oldest regional bank CEOs, which raises the probability that the bank will be sold. Expectations are bombed out at this point, so we think it’s time to move from bearish to bullish on TCB.

IGT

There is improving visibility on 20%+ EPS growth with P/E of only 11x with better content leading to market share gains. New orders from Canada and IL should be a catalyst. Additionally, many people in the investment community are out in Las Vegas at the annual slot show (G2E) and should hear upbeat presentations by management.

HCA

While political and reimbursement risk will remain near-term concerns, on the fundamental side we continue to expect accelerating outpatient growth alongside further strength in pricing as acuity improves thru 1Q13. Flu trends may provide an incremental benefit on the quarter and our expectation for a birth recovery should support patient surgery growth over the intermediate term. Supply costs should remain a source of topline & earnings upside going forward.

Three for the Road

TWEET OF THE DAY

“Becky is grilling a $JCP analyst right now on Sqwawk. Sad to see people defend a name like this.#Sinking_ship.” -@HedgeyeRetail

QUOTE OF THE DAY

“Ambition is a poor excuse for not having sense enough to be lazy.” -Edgar Bergen

STAT OF THE DAY

JC Penney Q3 Same Store Sales fall 26.1%

11/09/12 07:44 AM EST

NOVEMBER (POST-SANDY) CRUISE PRICING

Some discounting but overall still solid pricing

Various Caribbean and Europe itineraries saw some discounting in the last month, but that was offset by pricing improvements in other regions. Costa pricing remains steady in Europe while its venture into Asia has garnered solid pricing. We see pricing strength in the very close-in Caribbean bookings for CCL’s F4Q. Overall, F1Q pricing for RCL and CCL continue to exhibit weakness but both companies stressed F1Q will be a difficult quarter due to tough comps pre-Costa Concordia. The good news for F1Q is that Asia Pacific/South America/Mexico account for ~30% of the total itineraries and those regions have had better pricing. For early F2Q, pricing trends improved for Alaska, Asia Pacific and Mexico while Europe pricing remained status quo in November.

While the ‘Sandy and Athena’ card could be effectively used by Carnival and Royal Caribbean to mask weak F1Q 2013 guidance, the rest of 2013 remains to be seen until the upcoming Wave Season. Although there will surely be bumps along the road, we continue to be encouraged by the pricing stability out of Europe, a relatively low capacity environment and better visibility due to higher booking volumes.

Here are some conclusions from our cruise pricing survey completed this week. The charts below track pricing trends on a relative basis—i.e. prices relative to that seen on the last earnings call (RCL – Oct 25, CCL –Sept 25).

FQ4 2012

Caribbean

Pricing was mixed in November. For the very last-minute bookings, the Carnival brand continues to improve on pricing in spite of Sandy. RCL brand pricing wasn’t so lucky but given Celebrity’s strength pre-Sandy, the Caribbean may still retain the top spot in yield growth.

Europe

Most of the Costa itineraries maintained their pricing; discounting in a couple of Spanish itineraries pushed overall pricing a tad lower.

Asia Pacific

Not much movement from October to November

FQ1 2013

Caribbean

Royal and Celebrity pricing both slipped in November. While modestly negative YoY, Carnival’s pricing improved slightly in November.

Europe

Cunard pricing dropped as this brand has had trouble maintaining price in the past few months

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